State and local governments finance multi-year expenditures by issuing municipal bonds. To reduce the borrowing costs of state and local governments, municipal bond income is excluded from federal and, in most cases, state taxation. This tax advantage creates a tax expenditure for the federal and state governments, which is forecast to cost the federal government alone more than $500 billion over the coming decade. It has been rising over time, and is mainly enjoyed by top-income individuals. Not surprisingly, the tax advantage of municipal bonds has been the subject of a controversial policy debate.

This paper contributes to this debate by showing that the interaction between tax advantages and the structure of municipal bond issuance market, plays a crucial role in determining the effect of tax advantages on borrowing rates and the efficiency of this subsidy. Specifically, the authors analyze a novel dataset on over 14,000 new issuances of municipal bonds sold at auction between 2008 and 2015. The authors exploit within-state changes in taxes over time to show that tax advantages have large effects on the borrowing costs of state and local governments. They then develop an empirical auction model that clarifies the economic mechanisms in this market. Finally, they use the estimated model to evaluate recent proposals by the Obama and Trump administrations, as well as parts of the Tax Cuts and Jobs Act of 2017 (TCJA17) that affect the tax advantages of municipal bonds. By highlighting the interactions between taxes and imperfect competition, their results suggest a fundamental reassessment of the mechanism through which tax subsidies reduce borrowing costs, and provide new evidence suggesting that tax subsidies may be more efficient at subsidizing local borrowing costs than previously thought.

The rest of the paper is organized as follows. The authors describe the institutional context and their data in Section 2. Section 3 describes reduced-form relationships between tax advantages, borrowing costs, and imperfect competition in auctions for municipal bonds. In Section 4, the authors develop an auction model for municipal debt with tax advantages. Section 5 describes the estimation procedure and results of this model, and Section 6 explores the mechanisms through which taxes influence municipal borrowing costs. The authors simulate the effects of policy counterfactuals in Section 7. Section 8 concludes.

The authors did not receive financial support from any firm or person with a financial or political interest in this article. None is currently an officer, director, or board member of any organization with an interest in this article.

Homeownership lies at the heart of the American Dream, representing success, opportunity, and wealth. However, for many of its citizens, America deferred that dream. For much of the 20th century, the devaluing of black lives led to segregation and racist federal housing policy through redlining that shut out chances for black people to purchase homes and build wealth, making it more difficult to start and invest in businesses and afford college tuition. Still, homeownership remains a beacon of hope for all people to gain access to the middle class. Though homeownership rates vary considerably between whites and people of color, it’s typically the largest asset among all people who hold it.

If we can detect how much racism depletes wealth from black homeowners, we can begin to address bigotry principally by giving black homeowners and policymakers a target price for redress. Laws have changed, but the value of assets—buildings, schools, leadership, and land itself—are inextricably linked to the perceptions of black people. And those negative perceptions persist.

Through the prism of the real estate market and homeownership in black neighborhoods, this report attempts to address the question: What is the cost of racial bias? This report seeks to understand how much money majority-black communities are losing in the housing market stemming from racial bias, finding that owner-occupied homes in black neighborhoods are undervalued by $48,000 per home on average, amounting to $156 billion in cumulative losses.

The 2016 election revealed a dramatic gap between two Americas—one based in large, diverse, thriving metropolitan regions; the other found in more homogeneous small towns and rural areas struggling under the weight of economic stagnation and social decline.

This gap between two American geographies came as a shock to many observers.

While it is true that many American leaders had grown disconnected from a significant portion of the country, something else had happened, too: the nation’s economic trends had changed.

For much of the 20th century, market forces had reduced job, wage, investment, and business formation disparities between more- and less-developed regions. By closing the divides between regions, the economy ensured a welcome convergence among the nation’s communities.

However, in the 1980s, that long-standing trend began to break down as the spread of digital technology increasingly rewarded the most talent-laden clusters of skills and firms.

As the economy changed, convergence gave way to divergence, as a fortunate upper tier of big, dense metropolitan areas (the top 2 percent of U.S. communities based on measures of growth and wages) began to consistently grow faster than the median and least-prosperous cities.

By the present decade, a clear rank-ordered hierarchy of economic performance by community size had emerged.

Big, techy metros like San Francisco, Boston, and New York with populations over 1 million have flourished, accounting for 72 percent of the nation’s employment growth since the financial crisis. By contrast, many of the nation’s smaller cities, small towns, and rural areas have languished. Smaller metropolitan areas (those with populations between 50,000 and 250,000) have contributed less than 6 percent of the nation’s employment growth since 2010 while employment remains below pre-recession levels in many ‘micro’ towns and rural communities (those with populations less than 50,000).

As a result, few can now deny that the geography of America’s current economic order has brought economic and social cleavages that have spawned frightening externalities: entrenched poverty, “deaths of despair,” and deepening small-town resentment of coastal cosmopolitan elites. It is baleful realities like these that caught many politicians, academics, and journalists off guard in 2016 as they poured through post-election red-blue maps. In a very real way, the 2016 election of Donald Trump represented the revenge of the places left behind in a changing economy.

So now what? Fortunately, an outbreak of new thinking is raising the possibility of a response. Most notably, a growing chorus of voices is concluding that a new set of understandings and policies is needed to push back against today’s epidemic of divergence and to knit the country back together. Scholars, journalists, politicians, local leaders, and investors are all beginning to reassess the costs of inaction after decades of exactly that. No longer does nonchalance about the pulling away of “superstar” cities and the decline of “left-behind places” seem tenable.

Which is why we believe it is time to counter many economists’ and policymakers’ optimistic faith in the natural “catch up” of lagging places with a new focus on boosting economic opportunity for left-behind communities and residents in the United States.

Along these lines, we think the current moment requires robust national action to push back against the divergent features of today’s digitally super-charged economy. This will require developing new ways of thinking and new strategies to combat the threat of uneven development. Traditionally, regional development policies have taken two distinct forms: spatially-blind, “people-based” policies that seek to maximize economic efficiency by supporting the natural emergence of dynamic high-value, big-city economic activity, and “place-based” policies that try to achieve regional equity to ensure more regionally inclusive economic growth. What is actually needed, by contrast, is a mixed strategy that respects the efficiency of hubs of concentrated economic activity but seeks to extend this kind of dynamism to more regions by ensuring access to the basic prerequisites of high-quality growth.

Therefore, we favor a third approach to regional policy, something akin to what scholars Simona Iammarino, Andrés Rodriguez-Pose, and Michael Storper call “place-sensitive distributed development.” This approach assumes that regional equity won’t occur without economic development but that excessive imbalances between regions can jeopardize such development. Our place-sensitive strategy seeks to mitigate uneven development by ensuring economic growth occurs in a wider swath of regions.

What might place-sensitive distributed development look like in practice? To give a sense, we suggest five examples of the kinds of strategies that would help—three that focus on ensuring more regions have the assets and capabilities to flourish, and two more that suggest what specific regional development initiatives might look like. Here’s a look:

Boost the digital skills of left behind places. The workers, industries, and places that possess strong digital skills have enjoyed distinct economic rewards. To push back against this winner-take-all dynamic of today’s tech economy, every region’s workforce should be prepared to participate in the digital economy.

Ensure businesses in lagging regions have access to capital. The pullback in small business lending following the financial crisis has hit less densely populated parts of the country particularly hard. Efforts to improve data on small business performance can help banks lower the transaction costs of extending small loans while innovations in financial technology can help create a secondary market for them and reduce risk. Boosting alternative, non-bank sources of capital, such as venture capital funding, can also help support regional economic growth.

Reduce gaps in broadband. Large gaps in broadband service and subscriptions have put businesses and workers in less densely populated areas at a huge disadvantage. Policy proposals should focus on connecting more people and encouraging greater subscription rates in places already endowed with broadband.

Identify “growth poles” that can support regional growth. While it may be inefficient to “save” every left-behind small city or rural community in the U.S., targeted federal policy aimed at strengthening 10 or so promising mid-sized centers of advanced industry activity would bring more growth to some communities adjacent to many more lagging towns and rural areas. Federal investment in these “growth poles” will put more communities on a path toward self-sustaining economic growth.

Help Americans move to opportunity. The federal government should expand the availability of financial support for individuals who want to make long-distance moves to places promising greater economic opportunity. At the same time, federal policy should encourage states and localities to relax zoning restrictions and construct new housing units to increase the supply of affordable housing. For those who wish to stay in their communities to live but not necessarily to work, state and local governments could provide a subsidy for workers commuting to adjacent communities.

In sum, we need both people-based and place-based policies—and above all a “place-sensitive vision for distributed development”—to tamp down the nation’s deepening territorial divides. Our proposals represent a first sketch of what might work; they are meant to inspire additional creative thinking and experimentation in the coming years.

Inaction, after all, is no longer an option: the costs of spatial divergence to American economic and political life are now too great to ignore.

Although state and local governments in the U.S. have historically been regarded as some of the most financially sound entities, the aftermath of the Great Recession has cast doubt on this notion. The financial crisis also led to the collapse of most bond insurance companies, leaving the vast majority of obligations of state and local governments uninsured. At the same time, unmet needs for infrastructure investments, the bulk of which are typically funded by state and local governments, have been growing and estimated to amount to approximately $2 trillion in 2017.1 In the presence of these funding shortfalls, municipal entities have rapidly increased their reliance on private bank loans. Specifically, state and local governments have increased their bank loan obligations from about $30 billion before the financial crisis to over $160 billion in late 2016 (see Figure 1).

Figure 1. Volumes of bank loans and municipal bonds outstanding over time

Yet empirical evidence on this trend has been nonexistent. No disclosure requirements exist for private debt claims of municipal governments, and very few municipal entities choose to disclose voluntarily.2 Using confidential supervisory loan-level data on bank lending to municipal governments in the United States, Ivan Ivanov of Federal Reserve Board and Tom Zimmermann of University of Cologne study the municipal bank debt market. They first present key characteristics of the average bank loan contract to municipalities and discuss implications for debt seniority and potential claim dilution between private and public debt claims; then analyze banks’ internal assessment of the credit worthiness of municipalities and draw comparisons with that of rating agencies. Lastly, they study how exogenous adverse income shocks affect the debt structure of municipalities. This analysis helps understand whether the trend towards private debt claims is likely to persist in an environment of eroding fiscal positions.

They show that most of bank lending to states and local governments is done via credit lines, terms loans, and to a lesser extent leases.3 The majority of bank borrowing of counties, cities, and districts (both in terms of counts and funded amounts) is done via term loans. In contrast, states that have bank borrowing exhibit greater reliance on credit lines than local governments such as counties, cities, and districts. Additionally, municipal governments may have substantial additional ability to increase debt in a short time frame because of large unused revolving credit capacity.

The paper further demonstrates bank lending to state and local governments is heavily collateralized, has high contractual priority, and contains additional guarantees. For example, 60 percent of lines of credit and 80 percent of term loans are secured, with banks almost always having first-lien priority on the assets that secure the loans. Whenever a bank loan is unsecured, banks are almost always senior in terms of priority. In addition, bank loan maturities are short: only 2-3 years for lines of credit and 7-8 years for term loans. Overall, given the high collateralization of bank loans combined with maturities that are likely to be substantially shorter than those of public bonds, state and local governments with outstanding bonds may dilute public bondholders when they issue new bank loans. While such bonds claim dilution through collateralization and shortening of debt maturities may be a way to maximize external finance proceeds given the realization of an adverse income shock,4 it substantially limits the ability of a municipality to take on additional debt.

The authors did not receive financial support from any firm or person with a financial or political interest in this article. Neither is currently an officer, director, or board member of any organization with an interest in this article.

Local newspapers in the United States have been steadily declining in recent years. Accompanying this change was a decline in statehouse reporters who play an important role in gathering information about local governments and reporting it to their readers. Related academic studies in the political economy space show that geographic areas with reduced local media coverage have less informed voters and lower voter turnouts, removing the incentives of local politicians to work hard on behalf of their constituencies.

Despite the growing academic research on the real effects of media coverage on finance outcomes, it still remains an open question whether shocks to media coverage affect these outcomes in the long run. If a negative coverage shock such as a newspaper closure leads to increased government inefficiencies and informational frictions, then potential municipal lenders will likely demand higher yields to compensate for these effects. On the other hand, if there is high degree of substitutability between the affected media outlet and alternative, unaffected outlets, then there should be no effect on local financial markets in the long run. This effect could even be positive if these alternative sources of news provide more accurate and timelier information to their readers.

Pengjie Gao of the University of Notre Dame and Chang Lee and Dermot Murphy of the University of Illinois at Chicago, empirically examine how shocks to local media coverage affect long-run public borrowing costs. The municipal bond market provides an ideal setting for their study because the individual bonds are largely bought and sold by local investors, providing a more direct link between local media shocks and securities prices. They use local newspaper closures as a proxy for local media shocks, as the closures effectively cause large, discrete changes in local media coverage. Their main finding is that newspaper closures have a significantly adverse impact on municipal borrowing costs in the long run. Specifically, following the three year period after a newspaper closure, municipal bond offering yields increase by 5.5 basis points, while yields in the secondary market increase by 6.4 basis points; these results are significant at the 1% level. Further, these results are robust to a comparison of yields between affected and unaffected counties in the pre-closure period. The effect of newspaper closures on revenue bonds, which are backed by cash flows generated by specific projects and more subject to misappropriation, is even stronger, with offering and secondary yields increasing by 10.6 and 9.9 basis points. In dollar terms, an additional 10 basis points increases the cost of an average issue by about $650 thousand.1 Taken together, their evidence suggests that there is not a sufficient degree of substitutability between local newspapers and alternative information intermediaries for evaluating the quality of public projects and local governments.

The authors did not receive financial support from any firm or person with a financial or political interest in this article. Neither is currently an officer, director, or board member of any organization with an interest in this article.

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https://www.brookings.edu/blog/the-avenue/2018/08/07/landing-amazon-hq2-isnt-the-right-way-for-a-city-to-create-jobs-heres-what-works-instead/Landing Amazon HQ2 isn’t the right way for a city to create jobs. Here’s what works insteadhttp://webfeeds.brookings.edu/~/562955976/0/brookingsrss/topics/stateandlocalfinance~Landing-Amazon-HQ-isn%e2%80%99t-the-right-way-for-a-city-to-create-jobs-Here%e2%80%99s-what-works-instead/
Tue, 07 Aug 2018 15:06:25 +0000https://www.brookings.edu/?p=531595

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By Amy Liu

Amazon’s highly visible search for a second headquarters has offered one tremendous public benefit: it has raised public awareness of what bad economic development is. Even Saturday Night Live satirized the lengths to which local officials will go to woo a major company, which include offering massive amounts of taxpayer subsidies, despite dubious economic returns.

But if attracting Amazon and other companies is not the right way to create jobs, then what is?

To start, it’s easy to understand why local leaders pursue these business attraction deals: economic development is routinely mayors’ top policy priority, as new jobs can boost local employment rates, raise residents’ incomes, stabilize city budgets, and revitalize distressed neighborhoods. Landing a flashy new business headquarters is great PR, a highly visible way to show that leaders are directly helping local economies. This leads state and local governments to spend an estimated $45 billion on economic development subsidies and incentives each year, even when they rarely factor into corporations’ final decisions.

All this attention lavished on business recruitment overstates their importance to total job creation. One study by the Center on Budget and Policy Priorities estimates that attracting out-of-state businesses accounts for just three to 14 percent of all jobs created in a state each year. Furthermore, evidence suggests that the pipeline of corporate relocations is drying up, leading to spiraling subsidies for the few mega deals that do emerge.

Meanwhile, a mountain of research suggests that the bulk of job creation happens elsewhere. The Kauffman Foundation notes that fast-growing startups play an outsized role in job creation. Economist Gary Kunkle emphasizes the importance of “sustained growth” companies of all sizes, which add jobs steadily over several years, rather than in a single massive expansion. Other researchers, including Enrico Moretti, Michael Porter, and my colleague Mark Muro, point to the power of clusters — especially in tech-based advanced industries — for regional job creation. They note that close proximity to competitors and suppliers allows companies to share talent, supply chains, and infrastructure, leading to more innovation, growth, and spillover benefits in the form of new local jobs.

In short, the bulk of job growth comes from empowering existing people and businesses in a community to grow, innovate, and start new ventures. Local leaders and voters should demand this kind of good economic development, which then attracts other firms that want to be part of a dynamic local business environment.

Broadly speaking, here are three ways to grow jobs from within:

1. Invest in a start-up ecosystem. With economic dynamism on the decline in recent years, local leaders have been launching efforts to support early-stage companies. This can include investments in startup accelerators, which can provide resources and mentors to aspiring entrepreneurs, or efforts to build a more diverse pipeline of entrepreneurs within a region’s start-up ecosystem, as is taking place in San Diego and Atlanta.

2. Help small- and middle-market firms scale. Beyond start-ups, local leaders can also help existing small- and mid-sized establishments survive, innovate, and grow. Some communities, including Chicago, are helping small businesses expand their supplier relationships among a network of universities, hospitals, and other private sector institutions. Others provide customized services to small and mid-sized manufacturers. And some have focused on middle-market firms, which have the size and proven products to invest in continuous improvement, yet face unique challenges. Helping these companies find skilled workers, enter global markets, and access capital, as can be seen with one promising initiative in Philadelphia, can facilitate job growth.

3. Deepen industry specializations. San Diego’s life sciences specialization, Milwaukee’s water tech cluster, and Indianapolis’s bio health tech ecosystem were hardly the result of dumb luck. Instead, a series of strategic moves by private and public leaders helped create competitive advantages in these sectors, as described in a recent Brookings report. This included bringing firms together, linking industry and university expertise to make the most of commercial opportunities, and making key public investments.

In short, the bulk of job growth comes from empowering existing people and businesses in a community to grow, innovate, and start new ventures.

These economic strategies benefit directly from a broader array of investments that matter to global competitiveness, such as transit-accessible job centers, modern air and logistics infrastructure, and industry partnerships with technical schools and colleges to help workers gain valuable credentials.

Meanwhile, since economic development incentives will not be going away anytime soon, local leaders should at least use them to reward firms that create quality jobs, locate in underserved neighborhoods, or commit to community benefits.

As the competition for Amazon’s second headquarters heats up in the remaining months, the real winners will be the cities that play in the game that counts—growing an inclusive, sustainable economy that invests in homegrown people and businesses.

The tax exemption for earnings on municipal bonds cost the federal government almost $31 billion in 2017. The exemption is intended to promote state and local investment, but many analysts argue the policy is an inefficient way to provide such a subsidy.

How is it that the tax benefit has such a large impact on state and local borrowing costs? Suárez Serrato and coauthors say lack of competition in muni bond auctions—which often include few participants who need specialized information about each municipality and bond issuance—allows powerful bidders to suppress the price of the bond below what they would be willing to pay in a competitive auction. When a tax increase raises the value of the tax exemption, additional investors join the auction and bid higher prices. The tax hike not only raises the price investors are privately willing to pay, but also makes the auction more competitive. As evidence for this hypothesis, the authors show the pass through from tax savings to borrowing costs is larger for bonds issued by school districts and smaller jurisdictions, where auctions tend to have very few bidders and often are private.

[T]ax exemption is an effective policy for subsidizing state and local governments, and that its removal could place substantial burden on municipalities.

What does this mean for the importance of muni bond tax exemptions? The Suárez Serrato analysis implies the tax exemption is an effective policy for subsidizing state and local governments, and that its removal could place substantial burden on municipalities. In an analysis of the effects of the recently enacted Tax Cuts and Jobs Act, the authors find the new law—which limits the deductibility of state and local taxes and hence raises the effective tax rate—may lower interest costs for municipalities by 2.5 percent. An Obama-era proposal to limit the deductibility of muni interest income, on the other hand, would lead to an increase in state and local borrowing costs of around 31 percent, on average.

Suárez Serrato and coauthors note that these large policy effects exist primarily because of inefficiencies in primary municipal bond markets. If the tax advantages turn into public savings because bond auctions tend to be uncompetitive, then policies aimed at increasing competition in municipal bond auctions could significantly lower borrowing costs without sending the bill to federal and state taxpayers.

New research reveals that big tax cuts can sometimes be worse for the fiscal health of states and localities than previously estimated. This is the finding of a new paper entitled “State Tax Cuts and Debt Market Outcomes,” to be presented at the 2018 Municipal Finance Conference at Brookings. In their paper, Komla Dzigbede of SUNY Binghamton and Rahul Pathak of Baruch College find that large tax cuts enacted in Kansas increased interest rates and reduced credit ratings on state and municipal bonds, compounding on the state’s already significant fiscal woes. Utilizing the Kansas tax cuts as a natural experiment, the authors show that the state-wide tax cuts created spillover into local municipalities that made it harder for them to borrow money.

In 2012, the Kansas legislature passed a bill that reduced individual income tax rates, reduced the number of income brackets from three to two, and eliminated taxes on so-called pass-through businesses, or S-corporations. A year later, the legislature passed another bill further reducing income tax rates, raising the state sales tax, and reducing the standard deduction. Newly elected Governor Sam Brownback described the tax cuts as a means to accelerate economic growth and job creation, calling them “a shot of adrenaline into the heart of the Kansas economy.” Despite increasing the state budget deficit by a wide margin, Brownback reasoned that an increase in economic growth spurred by the tax cuts would offset the initial decline in revenue. However, after facing significant budget shortfalls, the Kansas legislature in 2017 voted to override Gov. Brownback’s veto, and raised taxes by $1.2 billion, effectively reversing the tax cuts of 5 years earlier.

While there is contention over whether or not tax cuts increase economic growth, the direct effects of lower revenues can lead the fiscal condition of a state or locality to worsen.

Dzigbede and Baruch’s analysis expands upon the economic literature related to tax cuts and economic growth more broadly. While there is contention over whether or not tax cuts increase economic growth, the direct effects of lower revenues can lead the fiscal condition of a state or locality to worsen. This in turn could lead to higher borrowing costs and a lower credit quality of the securities issued by the borrowers, further compounding budgetary stress. If the effects on borrowing costs and credit quality are particularly large, the fiscal challenges of the state as a whole could also spill over into the fiscal picture of individual counties.

Utilizing data on individual bonds issued by the state of Kansas, as well as by Kansas municipalities, from 2005-2015, the authors estimate the change in total interest costs as well as changes in credit ratings after the tax cuts went into effect. The study compares the financing outcomes in Kansas to that of surrounding states. Controlling for factors related to the characteristics of each bond, the authors find that on average, the tax cuts led to an increase in interest rates for Kansas state-issued bonds of 0.43 percentage points and for local government-issued municipal bonds of 0.34 percentage points, compared to the neighboring states of Colorado, Nebraska, Missouri, and Oklahoma. In addition, the financial strain placed on the state and counties reduced the probability of municipal bonds receiving higher credit ratings (AA/Aa2 or above). This decline in credit ratings can account for roughly half of the increase in overall borrowing costs.

In light of these findings, the authors argue that the indirect financial implications of tax changes should be considered as part of states’ budget constraints when assessing the merits of any major tax policy. Additionally, the results from bond issuances among local municipalities suggest spillover effects from state to local financing conditions. Therefore, the authors argue localities should be given a voice in major state-level tax changes.

State governments with large unfunded pension liabilities are paying more to borrow from capital markets than are other states, according to Chuck Boyer of the University of Chicago Booth School of Business.

In the paper, “Public pensions, political economy and state government borrowing costs,” to be presented at the 2018 Municipal Finance Conference at Brookings this week, Boyer argues that markets view states with large pension deficits as riskier investments. His evidence suggests that states are already paying for municipal government’s unfunded pension liabilities in the form of higher borrowing costs. He asks two questions: 1) how are state governments’ borrowing costs affected by unfunded pension obligations? and 2) do states with political constraints face higher borrowing costs?

Boyer constructs a panel dataset using each state’s Comprehensive Annual Financial Reports for the period 2005 to 2016. He focuses on balance sheet variables—revenues, expenses, assets, and liabilities—to capture a state’s financial health and credit default swap (CDS) spreads – the premium paid to protect buyers from an issuer defaulting – to measure borrowing cost. The author reasons that CDS reflects market sentiments better than market yields because CDS are more liquid, and because they are standardized, whereas market yields may be affected by additional features of a particular bond.

Boyer’s results suggest that markets believe states with a higher liability-to-GDP ratio are riskier. He finds that states with lower deficits have lower CDS spreads: a one standard deviation change in the ratio is associated with a 0.18 percentage point change in CDS spreads. “This implies investors see pension liabilities and bonded liabilities similarly when assessing state level default risk,” writes the author.

Boyer also proxies a state’s political constraints by examining whether its pensions are protected by constitutional provisions, the degree of union membership, and the state government’s involvement in municipal bankruptcies. The author reasons that, “[I]n a state with more ‘senior’ pension liabilities, the government is likely to default on bonded debt before pensions.” Boyer finds evidence, albeit weak, that investors see political constraints on unfunded pension liabilities as contributing to default risk.